Posts Tagged ‘Incentives’

Harvard Business School professor Mihir Desai believes American companies and investment firms have erred–horribly–by linking manager compensation so tightly to financial market performance. In the current Harvard Business Review, he identifies this as a giant FIB, a Financial Incentive Bubble:

American capitalism has been transformed over the past three decades by the idea that financial markets are suited to measuring performance and structuring compensation. Stock-based pay for corporate executives and high-powered incentive contracts for investment managers have dramatically altered incentives on both sides of the capital market. Unfortunately, the idea of compensation based on financial markets is both remarkably alluring and deeply flawed: It seems to link pay more closely to performance, but it actually rewards luck and can incentivize dangerous risk-taking. This system has contributed significantly to the twin crises of modern American capitalism: governance failures that cast doubt on the stewardship abilities of U.S. managers and investors, and rising income inequality.

Mihir has nothing against well-functioning financial markets. He emphasizes that they “play a vital role in economic growth by ensuring the most efficient allocations of capital,” and he believes that capable managers and investors should be “richly rewarded” when their talents are truly evident.

The problem is that incentive compensation based on financial performance does a lousy job of distinguishing skill from luck. In finance-speak, managers and investors often get rewarded for taking on beta, when their pay really ought to be linked to alpha. In practice, luck gets rewarded with undeserved windfalls (that are by no means offset by negative windfalls for the unlucky). And that, he argues, results in an important “misallocation of financial, real, and human capital.”

Auto companies have made great strides in improving engine efficiency in recent decades. But those improvements haven’t done much to improve the fuel economy of America’s passenger car fleet. Instead, consumers have “spent” most of those efficiency improvements on bigger, faster cars.

MIT economist Christopher Knittel has carefully quantified these tradeoffs in a recent paper in the American Economic Review (pdf; earlier ungated version here). As noted by Peter Dizikes of MIT’s News Office:

[B]etween 1980 and 2006, the average gas mileage of vehicles sold in the United States increased by slightly more than 15 percent — a relatively modest improvement. But during that time, Knittel has found, the average curb weight of those vehicles increased 26 percent, while their horsepower rose 107 percent. All factors being equal, fuel economy actually increased by 60 percent between 1980 and 2006, as Knittel shows in a new research paper, “Automobiles on Steroids,” just published in the American Economic Review.

Thus if Americans today were driving cars of the same size and power that were typical in 1980, the country’s fleet of autos would have jumped from an average of about 23 miles per gallon (mpg) to roughly 37 mpg, well above the current average of around 27 mpg. Instead, Knittel says, “Most of that technological progress has gone into [compensating for] weight and horsepower.”

This is a fine example of a very common phenomenon: consumers often “spend” technological improvements in ways that partially offset the direct effect of the improvement. If you make engines more efficient, consumers purchase heavier cars. If you increase fuel economy, consumers drive more. If you give hikers cell phones, they go to riskier places. If you make low-fat cookies, people eat more. And on and on. People really do respond to incentives.

That’s good advice, as far as it goes. But it has a dark underside: managing the measurement rather than actual outcomes.

Over at the New York Times, Al Baker and Joseph Goldstein recount a troubling example. To keep reported crime rates low, New York’s Finest may be under reporting the crimes that actually occur:

Crime victims in New York sometimes struggle to persuade the police to write down what happened on an official report. The reasons are varied. Police officers are often busy, and few relish paperwork. But in interviews, more than half a dozen police officers, detectives and commanders also cited departmental pressure to keep crime statistics low.

While it is difficult to say how often crime complaints are not officially recorded, the Police Department is conscious of the potential problem, trying to ferret out unreported crimes through audits of emergency calls and of any resulting paperwork.

As concerns grew about the integrity of the data, the police commissioner, Raymond W. Kelly, appointed a panel of former federal prosecutors in January to study the crime-reporting system. The move was unusual for Mr. Kelly, who is normally reluctant to invite outside scrutiny.

The panel, which has not yet released its findings, was expected to focus on the downgrading of crimes, in which officers improperly classify felonies as misdemeanors.

But of nearly as much concern to people in law enforcement are crimes that officers simply failed to record, which one high-ranking police commander in Manhattan suggested was “the newest evolution in this numbers game.”

The United States can’t pursue al Qaeda alone. We need help from other nations. To encourage nations to provide that help, the U.S. created the Coalition Support Fund to reimburse coalition partners for the costs they incur fighting terrorism.

As Adam Entous reports in the WSJ, the prospect for such “reimbursement” creates an obvious incentive: our partners may exaggerate how much they are really spending:

The U.S. and Pakistan are engaged in a billing dispute of sizable proportions, sparring behind closed doors over billions of dollars Washington pays Islamabad to fight al Qaeda and other militants along the Afghanistan border.

Washington, increasingly dubious of what it sees as Islamabad’s mixed record against militants, has been quietly rejecting more than 40% of the claims submitted by Pakistan as compensation for military gear, food, water, troop housing and other expenses, according to internal Pentagon documents. Those records, reviewed by The Wall Street Journal, detail $3.2 billion in expense claims submitted to the U.S. for operations from January 2009 through June 2010.

According to the documents and interviews with officials, Pakistan has routinely submitted requests that were unsubstantiated, or were deemed by the U.S. to be exaggerated or of little or no use in the war on terror—underscoring what officials and experts see as a deep undercurrent of mistrust between the supposed allies.

It seems like only yesterday that I met Rocky. Probably because it was yesterday.

Our smallest cat Caramel was staring intently upward. Following his gaze, I spied Rocky tucked between two branches high in the silver maple near our deck.

Rocky didn’t look well. Raccoons aren’t usually out and about at 3:00 on a sunny afternoon. Lounging in the sun isn’t their thing.

Esther and I thought about calling the animal control authorities–rabies is not unheard of around here–but decided to wait until morning to see if Rocky looked better. No point harassing (or worse) the poor guy if he’s just an eccentric raccoon who wanted some sun.

A higher authority came calling overnight, though, and Esther found Rocky motionless under our deck.

Wild animals are one of my domestic responsibilities, so it fell to me to go poke Rocky with a stick to check his status. Result: deceased.

So what do you do with a dead raccoon?

This is precisely the sort of question at which the web excels. Sure enough, “dead raccoon” generates more than 30,000 hits on Google. But they boil down to only three flavors of advice: (1) Do it yourself, (2) Make it someone else’s problem, or (3) Turn it into a media sensation by claiming you’ve discovered a monster.

#3 wasn’t really an option – Rocky was clearly a raccoon — so I tried the nice version of #2, calling Montgomery County Animal Control to see if they handle deceased raccoons. No dice. If the deceased is on your property, it’s your responsibility – bag him and put in the trash was the advice. If he were on a county road, however, that would be a different matter. Then the county would pick him up.

Fair enough. Property rights ought to convey responsibilities as well as ownership. I’m good with that. But I couldn’t miss the implied incentive. If I were so inclined, I could simply pick Rocky up, suitably attired in latex gloves etc. (me, not him), and deposit him by the curb. I suspect such littering is a popular strategy. People do respond to incentives after all. See, e.g., Stacey Robinsmith’s dead raccoon trilogy.

Being a respecter of property rights and embracer of responsibility, however, I went with option #1. Here are some tips if you ever find yourself in a similar circumstance:

Raccoons have claws; use extra bags. Several cheery folks recommended putting Rocky in a trash bag. Well, his claws sliced right through that when I placed him inside. I ended up going with a full-on Babushka doll solution – five nested bags. That might have been a teensy bit excessive. But I suspect the garbage collectors will appreciate it.

Burial would, of course, be a more natural solution. But given the number of dogs, cats, and other critters that roam the neighborhood and dig better than I do, that seemed like a bad idea with Rocky’s suspicious cause of death.

In national surveys, insecurity ranks at the top of the most serious concerns of Afghan businesses. However, discussions with local business owners revealed a critical qualification to this finding. Surprisingly, Afghans were more concerned with the uncertainty of the business environment than with physical insecurity. In Kandahar, which is considered one of the most dangerous areas of the country, conversations with business people highlighted uncertainty about the quality and timing of the power supply, about supplies flowing in through the border crossing of Spin Boldak, about the local/national government, about financing,about American force posture and about the sanctity of obligations should political power shift – more than security issues. In Kabul, two manufacturers noted that they had received seven-year tax break guarantees from a minister of finance only to see them rescinded by his successor. This act understandably rendered the companies reluctant to make subsequent investments.

So how do Afghanistan’s entrepreneurs respond to this uncertainty? Cusack and Malmstrom find that “businesses adapt by integrating vertically, emphasizing short-term profits and ‘buying’ security”:

Businesses employ a number of common strategies to adapt to Afghanistan’s uncertain business environment. First, they seek to vertically integrate operations, generally within family and tribe, to minimize reliance on untrustworthy business partners and the government. “We have the most corrupt government and people in the world. I don’t like relying on people outside of my family if I don’t have to,” stated Mohammad Jalil Rahimi, General Manager of the Mazar-based Barakat Group, an import-export conglomerate. The process of vertical integration begins around a central business, often import-export, and grows to include supporting businesses, such as transportation and logistics. It can then grow to include other sectors such as construction, agriculture and light manufacturing.

Second, businesses seek to remain as flexible as possible in order to hedge against uncertainty, valuing short-term but dependable gains over developing long-term productive capacities. A Western official explained, “Afghans go to the highest-margin businesses that require the least amount of capital and that produce benefits in the least amount of time.

This means that they often start in trade, then pick productive business opportunities in services, agriculture and construction. But even then, people are loathe to invest in manufacturing versus trade because it is easier and quicker.” Despite this adaptation, producers continue to face challenges from a variety of sources. For instance, a Mazar cable and wire producer was being put out of business due to competition from cheaper Iranian imports; a Jalalabad-based box manufacturer could not afford his onerous credit payments, was accumulating debt and was unable to sell his business; and a Kandahar beverage company could not convince needed Pakistani technical engineers to visit and repair manufacturing breakdowns.

We observed four primary strategies for managing physical insecurity: 1. shifting operations away from unstable areas; 2. negotiating with government or insurgent power brokers, often through payment of informal taxes and bribes; 3. allocating up to 20 percent of an operating budget to formal security costs, including a security director, guards, etc.; or 4. implementing community-based strategies in cooperation with local elders and staff. The choice businesses make depends on an individual business’ toleration of risk, past experience and influence within society. An Afghan mining executive explained his predicament: “I can’t complain to the police or the government because it will make the problem bigger. My only strategy is to negotiate directly with the Taliban. My last option is to pay them. But I don’t want to pay them because it will make them stronger.”